By Sam Maness

A good estate plan covers most of what you need for legacy planning, but far too many retirees turn a blind eye to how the plan provides for retirement assets. And here's the kicker - your estate plan, no matter how good, doesn't govern the transfer of your retirement accounts - including any IRA, 401(k), 403(b), or 457(b).

Retirement plans require account owners to execute "beneficiary designation forms" and then transfer assets directly to whoever is listed on the form, regardless of what you write in your will or trust. With many retirees holding six and seven-figure nest eggs in these accounts, planning ahead is critically important. I wrote another article about the rules for taking distributions from your retirement accounts; the focus now shifts to properly designating beneficiaries to inherit those assets.

Beneficiary designations are most at risk during transitions and after major life events (think marriage, divorce, and estate planning). Marriage removes some of the guesswork, but not always. Most 401(k) and similar work retirement plan have protections for the spouse but this isn't always true for IRAs. You could inadvertently exclude your spouse, or include your ex, as the recipient of your retirement money. And with legacy and estate planning, poor planning could inadvertently direct more of your family's inheritance to the government tax collectors. This primer offers a few ways to better protect you and your family when it comes to retirement money.

Introduction to Inherited Retirement Accounts

One of the key benefits of retirement accounts is tax-deferral. Money is invested within the account and grows tax-free until the time of withdrawal, when it is recognized as ordinary income. The government won't let us defer taxes forever, so they set rules to ensure account owners withdraw a required minimum distribution, or RMD, amount each year.

The distribution options available depend on your relationship to the original account owner, and whether the original account owner died before or after the "required beginning date" (deadline for taking the first distribution, April 1 in the year after the account owner reached age 70 ½). Also, it depends on whether or not multiple beneficiaries were listed on the account.

Practical Tips:

    If the original account owner dies after the required beginning date, make sure you satisfy the current-year RMD before taking any additional action.

    Always review an employer plan if you aren't moving the account to a new or existing IRA. Some plans require distributions within five years, even if IRS rules provide additional options.

    Options for a Surviving Spouse

    A surviving spouse listed as the sole beneficiary has the option of completing a tax-free rollover to transfer assets to his or her own IRA. In most cases this is the preferred option. Even if there are multiple beneficiaries, the surviving spouse can protect "sole beneficiary" status by creating a separate account no later than Dec. 31 of the year after the account owner's death. Here is a complete list of available options:

    Account owner dies after the age 70 ½ required beginning date:

    • Spousal transfer to your own IRA: distributions based on your life expectancy; withdrawals starting no later than your required beginning date
    • Keep account or open an inherited IRA: distributions based on your life expectancy; withdrawals starting no later than Dec 31 in the year the original account owner would have reached age 70 ½
    • Lump sum distribution

    Account owner dies before the age 70 ½ required beginning date:

    Same as above, with the additional option of:

    • Keep account or open an inherited IRA: distributions in 5 years; withdrawals starting no later than December 31st in the year after the account owner's death

    Options for Non-Spouse Beneficiaries

    Account owner dies after the age 70 ½ required beginning date:

    • Keep account or open an inherited IRA: distributions based on your life expectancy or the account owner's life expectancy (whichever is greater); withdrawals starting no later than Dec. 31 in the year after the account owner's death; Lump sum distribution

    Account owner dies before the age 70 ½ required beginning date:

    • Keep account or open an inherited IRA: distributions based on your life expectancy; withdrawals starting no later than Dec. 31 in the year after the account owner's death
    • Keep account or open an inherited IRA: distributions in 5 years; withdrawals starting no later than Dec. 31 in the year after account owner's death
    • Lump sum distribution: No Designated Beneficiary (Includes charities, estates, and some trusts)

    Account owner dies after the age 70 ½ required beginning date:

    • Account distributed based on the original account owner's life expectancy, withdrawals by Dec. 31 in the year after the account owner's death

    Account owner dies before the age 70 ½ required beginning date:

    • Account must be distributed by the end of the fifth year after death (i.e. account owner dies in 2020, distribution by Dec. 31, 2025)

    Multiple Beneficiaries

    You can stretch distributions based on the life expectancy of the oldest beneficiary, and withdrawals must start no later than Dec. 31 in the year after the account owner's death. Problems can arise when:

      You have beneficiaries on different generational tiers or with large gaps in age: A grandchild (age 14) could be forced to accelerate distributions based on the life expectancy of the account owner's sister (age 83).

      A charity, estate, or a trust receives a share: The account is treated as if there is no beneficiary, accelerating the distribution schedule and possibly requiring account liquidation within five years.

      Individual beneficiaries can open separate accounts by Dec. 31 in the year after the account owner's death - allowing each beneficiary to use his or her own life expectancy to calculate distributions.

      'Per Stirpes' Designations

      If you're listing multiple children and/or grandchildren as beneficiaries, you will want to consider including "per stirpes" designations. This provides that if a primary beneficiary passes away before you, the deceased beneficiary's interest is distributed to his or her heirs. Without the per stirpes designation, the share is instead divided among the remaining primary beneficiaries.

      Planning Tips: Divisions, Disclaimers and Distributions

      • If you list multiple beneficiaries, consider dividing your assets or establishing separate accounts before death with one account providing for living beneficiaries and a second for charities or entities.
      • The beneficiary determination date is Sept. 30 of the year after the account owner's death. Savvy planners can have charities and other problematic beneficiaries take distributions before the deadline - removing them from the equation for calculating the longest life expectancy.
      • A beneficiary can also make a qualified disclaimer of ownership, effectively passing the interest to the "next in line" set to receive the funds - the remaining primary beneficiaries if more than one listed, or the contingent beneficiary. The disclaimer deadline is nine months after the death of the account owner.

      The Problem(s) with Naming your Trust as Beneficiary

      A qualifying "see-through" trust can stretch RMDs based on the life expectancy of the oldest beneficiary. To qualify, Treasury Regulation 1.401(a)(9) requires a trust:

        be valid under state law,

        be irrevocable at or upon the death of the account owner,

        have identifiable beneficiaries, and

        timely provide the account custodian with trust documentation.

        Rule No. 3 above - identifiable beneficiaries - presents the most problems. If a charity or estate is included within the potential beneficiary pool, the trust fails to qualify, accelerating distributions (and taxes). Identifying beneficiaries isn't always easy and almost always requires a review of the trust language:

        • A "conduit" trust must distribute income and any additional withdrawals must be distributed to the beneficiary in the same calendar year, and needs to only consider "income" beneficiaries.
        • An "accumulation" trust is permitted to withhold or restrict income and withdrawals, and needs to consider income and remainder beneficiaries.

        Conduit trusts are fairly straightforward, and the beneficiary pool is limited. But many trusts are drafted with accumulation provisions to provide additional flexibility, requiring you to consider all remainder interests until a beneficiary can take immediate and outright ownership. If grandchildren are successor beneficiaries, any restriction on distributions - such as trustee discretion or an age requirement that hasn't been satisfied by the September 30th determination date - means you have to continue on and consider "mere successor" interests - such as a charity or other beneficiary that serves as the taker of last resort.

        Practical Tips

        If your trust is going to receive retirement assets, always work with a qualified estate planning attorney for legal advice and consult with your financial planning team. This is not a "DIY" project. Here are a few things that you and your advisory team should be thinking about:

          In some limited situations, trust beneficiaries can use their own life expectancy to stretch RMDs for retirement assets (instead of using the oldest beneficiary): If your trust document allows or specifically creates sub-trusts for individual beneficiaries, consider listing those within your retirement account beneficiary designation forms. Or, draft a stand-alone retirement benefit trust (or trusts) to receive retirement assets. The limited purpose of the trust can help avoid risks associated with more comprehensive and broadly-worded accumulation trusts.

          Be careful when funding specific monetary bequests from a trust using retirement assets. Without a good lawyer and the right trust language, it could trigger the much higher trust income tax treatment, even if the money goes to charity.

          A trust with accumulation provisions presents additional risk of failing the 'see-through' test when you have (1) a Special Needs Trust, (2) general powers of appointment, or (3) language allowing the payment of estate taxes, debts, or administrative expenses after the Sept. 30 beneficiary determination deadline.

          About the author: Sam Maness is a financial adviser with McLaren Wealth Strategies at 315 E. Eisenhower Ave, Suite 301, Ann Arbor, Mich. 48108. You can contact the McLaren team at mclarenwealth@raymondjames.com or 1-866-944-7556. Opinions expressed are those of the author and not necessarily those of Raymond James Financial Services. The information has been obtained from sources considered to be reliable, but we do not guarantee that the foregoing material is accurate or complete. Please note, changes in tax laws or regulations may occur at any time and could substantially impact your situation. Raymond James financial advisers do not render advice on tax or legal matters. You should discuss any tax or legal matters with the appropriate professional. Links are provided for information purposes only. Raymond James is not affiliated with and does not endorse, authorize or sponsor any of the listed websites or their respective sponsors. Securities offered through Raymond James Financial, Inc. Member FINRA/SIPC. Investment advisory services offered through Raymond James Financial Services Advisors, Inc. McLaren Wealth Strategies is not a registered broker/dealer and is independent of Raymond James Financial Services, Inc.